Weekly credit insight

Chart of the week: record extension risk proves the importance of being active

Extension risk in the high-yield market, measured as difference between the duration to worst and duration to maturity, is at highest recorded level – and the coronavirus could trigger that extension.

Credit markets performed strongly in 2019, with global high yield returning nearly 15%. Widespread economic uncertainty soured appetite for growth assets and interest rates hit all-time lows, creating a positive technical backdrop for credit – emphasised by the stock of negative-yielding fixed-income assets hitting a record high of $17tn during the year.

Given this performance, many bonds have rallied to trade to their next call date rather than maturity. Securities that were previously analysed in the context of seven-to-10 years to maturity are now seen as having one-to-three years to call, therefore reducing the duration of the market and dampening volatility (see figure 1).

Figure 1. At the limit: extension risk in the high-yield market

Source: Hermes Credit, ICE Bond Indices, as at January 2020.

This is exacerbated by several other factors: first, the record-low interest-rate environment has suppressed coupons; second, the large number of rising stars in recent years reduced the volume of longer dated bonds and non-callable bonds; third, non-call periods have generally shortened in the past few decades.

What can credit investors do? Focusing on the more liquid sections of the market, an intensely active approach combining top-down and bottom-up views is an appropriate course of action, in our view.

This relays important lessons. Unconstrained top-down allocation allows investors to avoid areas of the market with acute problems, like European high yield at the moment, in favour of others, like the US and emerging markets. Second, heightened extension risk currently makes security selection extremely important, and investors should be mindful of misleadingly low volatility when sizing positions.

Such considerations should come naturally to active credit investors. How deeply they are investigated is a question of conviction.

Andrey joined the international business of Federated Hermes in January 2013 and is co-portfolio manager on the range of credit strategies. He joined from C-Quadrat Asset Management, where he managed the multi-strategy credit fund and generated investment ideas for a range of absolute return credit funds. Andrey holds an undergraduate degree in Economics from State University – Higher School of Economics in Moscow, where he majored in Financial Engineering and Mandarin Chinese, and a graduate degree from London Business School. Prior to moving to London he worked in various roles in Russia and China. In 2019, Andrey was named in the Financial News’ ‘Top 25 Rising Stars under 40 in European Asset Management’ and has been selected to join the leadership team of Next Generation Fixed Income Portfolio Managers network, a CFA UK initiative to bring together the leading portfolio managers in the UK. Andrey is a native Russian speaker and CFA charterholder.